Developed-Markets Stocks Looking Cheaper

I write an article in the monthly Morningstar InternationalInvestor newsletter that looks at Morningstar's international coverage from a macroeconomic perspective. This macro view provides insight into how oversold the market currently is. In order to provide a margin of safety, we want to buy stocks at a significant discount to fair value. In this article, I've updated two charts that provide useful information in identifying how big the margin of safety is for the market.

One table shows the median price/fair value ratio of Morningstar's coverage of U.S. stocks, international stocks, and then international stocks broken down into developed markets and emerging markets. This ratio computes the current stock price divided by Morningstar's fair value estimate. A ratio of 1 says the stock is trading exactly at our fair value, anything below 1 shows the stock at a discount and anything above 1, at a premium. The median is the point where half the stocks have a higher ratio and half have a lower ratio. I use the median instead of the mean (or average), because some very expensive stocks can skew the mean higher and make stocks in general look more overvalued than they really are.

The other chart graphically shows Morningstar's star ratings by uncertainty rating, broken out by developed markets and emerging markets. These graphs allow the reader to quickly see the distribution of rankings of Morningstar's international coverage. The star rating is dependent on the discount or premium of the stock to our fair value estimate as well as the uncertainty rating of the stock. The higher the uncertainty rating, the greater the discount needed to increase the star rating. I developed these graphs because I wanted to take the median price/fair value ratio a step further and look at the percentage of stocks per star rating.

Following both charts over time provides information about how over- or undervalued international markets are. Currently (calculations as of Sept. 15) the median price/fair value ratios are the lowest in the two and a half years we've tracked them, with the median international stock at 0.75. This means the median stock is trading at a 25% discount to our fair value estimate. The graphs also show a tie with the previous month for the most 5-star rated international stocks we've had.